Swimming with Sharks: Why are Merchant Cash Advances So Popular?

Convenience Has a Price

Would you pay $100 for four hours of housing? After all, that equates to $18,000 per month!

Yotel Schiphol Airport
Yotel Schiphol Airport

You might, if you wanted to grab a shower and a couple hours of sleep between flights at Amsterdam’s Schiphol Airport. That’s roughly what it costs for a little respite in a YOTELAIR cabin – a brand of the emergent class of “pod” or “transit” hotels.

While the cost of long-term housing – rent or mortgage payments – is typically expressed in dollars per month, it wouldn’t make any sense to describe a YOTEL cabin as costing $18,000 per month. Such a room is designed for very short-term use.

A merchant cash advance (“MCA”), when used appropriately, is the pod hotel of the financing world. An MCA represents convenient access to capital at a price. When expressed in terms of annual percentage rate (“APR”), the cost of an MCA is often 50% or more. Does that make the cost outrageous? No, not any more than $100 for four hours for a small hotel room in an airport is inherently outrageous. The problem with MCAs stems from their inadvertent misuse.

Merchant Cash Advances Aren’t (Technically) Loans

A merchant cash advance is structured as a purchase of future credit card receivables. As such, an MCA is not considered a loan, nor is it subject to state usury laws that regulate interest rates. The MCA has emerged as a popular form of financing in recent years as banks have continued to withdraw from the small business lending market. Providers include PayPal, American Express, and Shopify Capital as well as a host of lesser known companies. Merchant cash advances are typically available to borrowers that have been in business for a year or more and which have annual credit card sales of $100,000 or more.

This is how an MCA works:

  • The advance amount is typically limited to 1.0 to 1.5 times your average monthly card sales. So, if your monthly card sales are $20,000, the advance amount might be between $20,000 and $30,000.
  • The payback amount will usually be between 1.1 to 1.5 times the advance amount. That is, if you are advanced $20,000, you’re likely to need to repay somewhere between $22,000 and $30,000.
  • Repayments or remittances are most often expressed as a percentage of your daily credit card sales. The remittance rate may range from 10% to 15% of sales. For example, $20,000 of monthly card sales translates into daily sales of $667, so your daily payment would be between $67 and $100 until cumulative payments equal the payback amount. If the payback amount was $25,000 and your remittance rate 15%, you would expect to repay your advance in 250 days (about 8 months). Anticipated repayment periods will typically range between 180 and 360 days.

Providers of merchant cash advances emphasize three advantages of this form of short-term financing:

  • Ready availability – most companies that have been in business for a few months, have demonstrated annualized credit card sales of at least $100,000, and are owned by somebody with a better-than-awful credit score are likely to be offered a merchant cash advance.
  • Quick turnaround – the application process often takes just a few minutes; approval often requires minutes or hours; and funds usually are made available within a day. In many cases, collateral or a personal guarantee are not required. Compared to applying for a bank loan, getting a merchant cash advance is drop-dead simple.
  • Flexible repayments – daily payments go up and down with credit card sales. There isn’t a fixed repayment schedule, which is the case with term loans. That may provide a little breathing room when sales are lower than expected (but it also works to accelerate repayment when sales are higher than anticipated).

Merchant Cash Advances Aren’t Cheap

The cost of a merchant cash advance is sometimes expressed in terms of discounts, fees, or payback multiples. So, many experts recommend calculating the implied APR. Fortunately, there are lots of useful calculators available online, including this one:

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Enter the following assumptions as an example:

  • Monthly Card Sales = $20,000
  • Advance Amount = $20,000
  • Remittance Rate = 15% (% of future card sales)
  • Payback Amount = 1.25 × Advance Amount = $25,000

The calculator yields an APR of 68%! When compared to a bank loan having an APR of 8%, that seems egregious. So why do people use merchant cash advances? There are several possible explanations:

  • As long as the MCA represents a relatively small portion of a company’s total financing, the convenience of a merchant cash advance to finance short-term requirements may be compelling – like a pod hotel cabin after a transAtlantic flight.
  • Borrowers don’t fully understand the conditions under which an MCA might be appropriate.
  • Providers of merchant cash advances are exploiting borrowers who feel backed into a corner by a pressing need for cash.

The Dark Side of Merchant Cash Advances

Opportunity Fund provides microloans to small businesses in California. It’s also a signatory to the Small Business Borrowers’ Bill of Rights. Opportunity Fund recently authored, “Unaffordable and Unsustainable: The New Business Lending.” It sees a growing number of small business borrowers who – despite being profitable – cannot get out from under crushing MCA obligations.

While some of these new alternative lenders are responsible companies that use new technologies to lower costs and deliver affordable and fair credit, the majority are peddling short-term and high-cost products that subject borrowers to opaque and often draconian terms, steep repayment obligations, and astonishingly high annual interest rates.

I can think of several reasons companies might find themselves in that position:

  • Merchant cash advance providers describe the terms of their products in abstruse language that is difficult to understand, particularly for non-specialists.
  • A remittance rate of “only” 10% to 15% of daily revenue represents most or all of the operating profit that a small manufacturer, for instance, might expect to generate. That doesn’t represent flexible repayment.
  • Many companies can’t grow themselves out of their financing needs. The faster they grow their sales, the more outside financing they’ll need. Consequently, what may look like a temporary need for cash becomes a long-term need.

Let me elaborate on that last point. A manufacturing company that sells product to wholesale customers might have $0.25 of working capital (roughly speaking, accounts receivable plus inventory minus accounts payable) for every $1.00 of sales. That same company might have an operating profit margin of 15% of sales. That means for every $1.00 of new sales, the company needs $0.25 of additional working capital due to its growth. Although additional profit of $0.15 per dollar covers part of the need, it would still need $0.10 of external financing. Sales go up; profits go up; and net financing needs go up.

Shark-invested Waters

That airport pod hotel can start looking like Hotel California: “You can check-out any time you like, but you can never leave.” Your short-term merchant cash advance to support growth fuels the need for even more financing. You may find yourself in a trap, if you don’t plan ahead to refinance with more sustainable, longer-term debt. Before you know it, it’s as if you are paying $18,000 per month for your housing.

Appropriate Finance

Merchant Cash Advances make sense in a rather narrow set of circumstances. Too often, providers market them as an easy form of general purpose business financing. It’s up to us businesspeople to educate ourselves so we can make good financing decisions. By anticipating our future need for financing, we can create options.

Although a diminishing proportion of small businesses can access bank debt, there exist alternatives, like Opportunity Fund, that offer reasonably priced debt on terms that fit your business and objectives. Before you get in the merchant cash advance habit, check out alternative lending platforms such as Kiva or Able Lending. Granted, they aren’t as convenient as merchant cash advances. Accessing loans through these providers take foresight, time, and some effort. It might just save your business.